Bernanke Offers Broad Definition of Systemic Risk

Federal Reserve Chairman Ben Bernanke said “systemic risk” can be broadly defined, including unsafe amounts of leveraging by banks, gaps in regulatory oversight and the possibility that the failure of a large interconnected firm could lead to a breakdown in the wider financial system.

In a letter sent to Sen. Bob Corker (R., Tenn.), the Fed chief weighed into the debate over what should be classified as systemically risky in the context of overhauling financial regulation.

Corker is a member of the Senate Banking Committee, and has been involved in discussions about how that panel should tackle regulatory overhaul.

The letter, dated Oct. 30, came after Bernanke met informally with a number of Senate lawmakers to discuss his views on what was needed by the regulatory rewrite.

“Systemic risks are developments that threaten the stability of the financial system as a whole and consequently the broader economy, not just that of one or two institutions,” Bernanke said in the letter.

The issue of how to define systemic risk, and then how to manage it, in the new regulatory world being designed by lawmakers has emerged as one of the most hotly contested issues.

In the wake of last year’s financial-market meltdown, it became apparent to policymakers and regulators that they didn’t have a grasp on the events that led directly to the global economic collapse.

The high exposure to derivatives based on the U.S. housing market, the levels of leveraging of investment banks including Lehman Brothers Holdings Inc., which was forced into bankruptcy in September 2008, and the near-collapse of American International Group Inc. all are now seen as the types of systemic risks that need to be better handled in the future.

In the letter, Bernanke appeared to endorse the view that all prudential regulation of an individual firm, whether or not it is deemed to be systemically important, should be done by a single agency.

But those agencies don’t necessarily have the ability to cast an eye around the industry more widely, the letter said. Therefore, the Fed chief also approved of the creation of a council of regulators to broadly oversee risks to the financial marketplace.

“The broader task of monitoring and identifying systemic risks that might arise from the interactions of different types of financial institutions and markets–both regulated and unregulated–may exceed the capacity of any individual supervisor,” Bernanke said.

Legislation in both the House and Senate would include creation of such a panel. In the bill being prepared by House Financial Services Committee Chairman Barney Frank (D., Mass.), the Treasury Department and the Federal Reserve would retain significant control over the council.

The draft bill released last week by Sen. Christopher Dodd (D., Ct.) would give both agencies seats at the table, but the panel would be run by a separate individual, appointed by the president and confirmed by the Senate.

Bernanke, in his letter, didn’t express a view of which system he would prefer; the letter was written before Dodd’s bill was unveiled.